Success in cryptocurrency trading depends on many factors, but one of the most important is having an effective trading strategy. Devising and testing such a strategy is a process that requires care, patience and a deep understanding of the market. Taking solutions on the basis of feelings or intuition, without proper preparation and analysis, can lead to serious financial losses.
In this article we will take a closer look at different ways of testing trading strategies, its pros and cons. Regardless of your experience and level of knowledge, this information will assist you to have a deeper insight into the significance of testing and learn how to apply it in practice to improve the efficiency of trading on the crypto market.
What is trading strategy testing?
Backtesting a trading style is an integral part of the process of developing and evaluating its effectiveness.
The essence of backtesting is to backtest a trading method on previous price movements, reconstructing the conditions under which it should have generated triggers for entry and exit of trades. This provides an opportunity to analyze the results of each individual trade, as well as the overall profitability and risk metrics of the strategy over a period of time.
Backtesting is usually performed with the help of customized software or platforms that have access to historical market information and enable setting the parameters of the strategy being tested.
The backtesting process calculates a number of key indicators such as total profit/loss, maximum drawdown, profit/loss ratio, number of profitable and losing trades, average profit/loss and other important parameters. This data enables a trader to estimate a strategy’s yield potential, risk profile, and stability.
In addition, backtesting assists in identifying weak points of a strategy and determining the optimal settings for its parameters, such as indicator periods, stop and take profit sizes, position sizes, etc. This gives an opportunity to improve the strategy before it is actually used in the market.
It is important to realize that backtesting results don’t guarantee the same outcome in the future, as the market environment is always changing. However, backtesting is an indispensable tool for initial assessment and optimization of trading strategies before their implementation in real trading.
Preparation before starting the backtest
Before starting to backtest a trading strategy, thorough preparation is essential. This step is vital for getting reliable and valid results. Here are the basic steps that should be taken:
Clearly formulate the rules of the strategy. It is important to describe in detail the conditions for entering and exiting positions. This will avoid subjectivity in the backtest and ensure the accuracy of the results. For example, a simple systematic strategy may contain the following rules: «If indicator A crosses level B upwards, open a long position. If indicator X falls below level Y, take profit».
Determining the time period of testing. It is recommended to choose a sufficiently long period covering different market conditions: volatility, trends, consolidation. This will help to evaluate the strategy comprehensively.
Selection of tools and data sources. Make sure that historical data on asset prices are reliable and valid. Reporting and calculation software will also come in handy.
Creating reporting documentation. Develop templates to record all transactions, including in/out times, volumes, profits/losses. This will systematize the testing methodology.
Identify the size of the equity for the test. Imitate actual trading situations and fix an initial capital for the strategy. This will give an idea of the account dynamics.
Eliminate the influence of personal preferences. Strictly follow the rules of the strategy, do not let emotions influence backtesting decisions. Objectivity is critical. Some traders prefer a systematic approach precisely because it helps exclude emotional decision making.
Choose between manual and automated backtesting. There is software that can automatically test strategies on historical databases after parameters have been entered. However, a manual backtest, although more time-consuming, has the key advantage of being free.
What is the process of backtesting a trading strategy?
Consider the backtesting process on a specific trading strategy. Suppose we want to test a popular trading strategy named «Moving Average Crossover» to trade the BTC/USDT cryptocurrency pair.
This strategy is built on 2 moving averages (SMA) with different periods — a faster 20-period one and a slower 100-period one. Signals for entry and exit are formed as follows:
- The opening of a long position (buy) occurs when the price crosses the 20-SMA from top to bottom. This is called a «golden cross» and is considered as a buy signal.
- Closing a long position (sell) is done when the price crosses the 20-SMA from the bottom upwards, forming a «dead cross» — a sell signal.
It is important to note that we will only consider daily candles for signals. This means that even if the intersection happens on a shorter time frame, we will be waiting for validation on the daily graph.
Let’s take the period from the beginning of 2020 to the present day for analysis. The longer the interval, the more reliable the results will be, but it is enough for an example. Let’s note the signals in this period:
- Buy at $8300
- Sell at $11500
- Buy at $10700
- Sell at $9200
- Buy at $12000
The first deal brought a profit of about $3200, the second — a loss of $1500. The realized profit at the moment was $1700. We see frequent buy/sell signals with significant unrealized profit.
Further actions on the open position will depend on the appearance of signals to close it according to the system rules.
Thus, strictly following the rules of the strategy during backtesting on the historical period, we have evaluated its behavior and potential in different market conditions.
Results of trading strategy testing
After testing a trading strategy, the stage of analyzing and evaluating the obtained results comes. This is an extremely important step that allows us to comprehensively study the efficiency of the system.
First of all, it is necessary to analyze the overall profitability of the strategy on the tested data segment. Was it profitable overall? How much profit/loss would it have generated in absolute and relative terms? These baselines will provide a first indication of the approach’s promise.
However, you should not limit yourself to just the financial result. It’s essential to take into account other performance metrics as well:
- Volatility. Estimate the maximum drawdowns and ranges of capital fluctuations. This will show the risks and initial deposit size requirements.
- Frequency of transactions. Determine how active the system is — the number of signals per period. Excessive trading activity may entail high commissions.
- Win/loss ratio. The ratio of successful and unsuccessful trades. Quality systems have a high percentage of successful trades, even if the profit/loss is distributed unevenly.
- Average entry/exit prices. How close are they to the levels that are profitable according to market analysis? Too frequent late entries can point to deficiencies in the rules of the strategy.
- Duration of trades. Long-term open positions increase the risk of drawdowns.
Don’t limit yourself to just these metrics. Depending on your trading style and preferences, other assessment parameters might also be valid.
Final thoughts
The effectiveness of backtesting is directly related to the depth and quality of the analysis performed.
Many traders mistakenly focus only on profit/loss totals when evaluating backtest results. This approach is extremely superficial and does not allow revealing the true strengths and weaknesses of a trading system.
Expert analysis requires a comprehensive assessment of a number of metrics: volatility, risk profile, profit/loss distribution, entry/exit efficiency and others. Only a combination of these parameters can give an objective picture of a strategy’s performance in different market conditions.
Moreover, successful traders constantly adapt and optimize their trading approaches based on the data obtained. Backtesting isn’t a one-time action, but a continuous process of system improvement.
